One of the most widely promulgated falsehoods in investing is the notion that those managing publicly held companies are obligated to maximize shareholder value. In recent years, US companies have taken on record amounts of debt to fund share repurchases on a scale only exceeded in 2007, in the name of enhancing shareholder value.* Often undertaken at the behest of a vocal minority, these buybacks have served to enrich CEOs at the expense of other important stakeholders, diminish the health of our economy, and threaten the long-term future of our corporations. That there is no legal basis for this fixation on shareholder value is either poorly understood or conveniently ignored by much of the investing public. Thankfully, the doctrine of shareholder primacy is now being challenged with more vigor and frequency than ever before. It’s time to put to rest an idea that too often promotes myopic thinking and imperils long-term value creation.
Many observers trace the rise of shareholder primacy theory to the influence of economist Milton Friedman. In 1970, Friedman argued that the social responsibility of business is to increase profits. Six years later, in “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” academics Michael C. Jensen and William H. Meckling turned to agency theory to explain why it was the sole obligation of corporations to maximize profits. They posited that corporate executives acted as agents for the owners of the business, the principals. Maximizing shareholder value became a shared goal that served to align the interests of shareowners and management, the latter via generous incentive compensation plans.
What got lost along the way was that the goal of maximizing shareholder value has no foundation in US corporate law. Directors and officers of publicly held companies have general duties of loyalty and care to the corporations they serve, but not to shareholders of the firm. Lynn Stout, professor of corporate and business law at Cornell Law School, notes in The Shareholder Value Myth that “maximizing shareholder value is not a managerial obligation, it is a managerial choice.” Only during takeovers and in bankruptcy does US law give special consideration to common stockholders. Importantly, Stout also points out that shareholders are hardly monolithic. Hedge fund manager Carl Icahn has a different time horizon, risk tolerance, and objectives than the typical pension fund. Stout likens strategies to unlock shareholder value to “fishing with dynamite.” That is, short-term success is often at the expense of “aggregate shareholder wealth over the long term.”
The bull market that began in 1982 helped fuel a hostile-takeover boom, and corporate raiders commonly invoked the noble ideal of maximizing shareholder value as they sought leveraged buyouts, greenmail, spinoffs, and asset sales. The classic book Barbarians at the Gate: The Fall of RJR Nabisco is a fair depiction of the times. Today’s corporate raiders are called activist investors, and while the tools at their disposal may have changed, their motives are similar, and the recent surge in share repurchases suggests that CEOs are heeding their call. The result has been a buyback binge of epic proportions, almost certainly violating one of Warren Buffett’s cardinal rules of investing. In his 2011 letter to Berkshire Hathaway shareholders, Buffett said:
Charlie [Munger] and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions — even serious ones — are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted.
There’s little doubt that capital used to fund many buybacks over the past decade has been diverted from more worthwhile investments. As a result, innovation has suffered, crimping growth, and other important stakeholders, particularly employees, have been left behind. This is the argument put forth by William Lazonick, professor of economics at the University of Massachusetts Lowell, in “Profits Without Prosperity.” He notes that since the late 1970s, companies have migrated from a “retain-and-reinvest” approach to a “downsize-and-distribute” philosophy, resulting in chronic short-termism and accompanying social costs in the form of “employment instability and income inequality.”
Lazonick points the finger at stock-based executive incentive plans, buybacks run amok, and poor oversight on the part of corporate boards. CEOs at S&P 500 firms now have a majority of their pay tied to their firm’s stock price, which may explain the record $270 billion spent on buybacks in the first half of this year. In fairness, Lazonick distinguishes between good and bad share repurchases. He acknowledges that tender offers can be a viable strategy for buying back undervalued shares at a designated stock price, according to the precepts of Buffett. However, he considers most open-market purchases ill-advised and undisciplined, noting that companies have a track record of buying at inflated prices.
Lazonick boldly proposes reforming the system by disallowing open-market share buybacks; curbing stock-based pay and tying compensation to innovation; and giving board seats to taxpayers and workers. While his call for reform is likely to meet stiff resistance, Lazonick should be applauded for drawing attention to a critically important issue.
Rather than enriching themselves by buying back stock at prices near all-time highs, CEOs should instead reinvest in their businesses, including their employees. Doing so will drive long-term growth and sustainability for corporations and the economy at large, better balancing the interests of all stakeholders.
*An earlier version of this blog post characterized the scale of share repurchases as “unprecedented.”
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37 Comments
Hello David
I used to own a small business so at that time I was a CEO and a shareholder rolled into one so both interests were aligned.
Now I am a consultant to larger organizations where the CEO and the shareholders are different, creating what they call the "Principal Agent Problem".
Over the years I have followed the debate you describe so elegantly with interest as I have seen it from a number of perspectives.
I firmly believe that the only role of the CEO, his management team, and the Board should be to maximize shareholder value.
What is missing is for shareholders to ensure that the CEO and the Board of Directors are acting in their best interest, and not in the CEO's best interest.
Best interest has many definitions which should be defined by the shareholders, ranging from growing the top line, improving the bottom line, and if that is what they need, buying back shares, or even going private.
Shareholders need to manage the CEO who in turn needs to manage the company on behalf of the shareholders.
Speaking of activist investors - lord knows we need more of them, particularly in Canada where I live where the old boys clubs need to be retired - see the excellent example of CP Rail and Bill Ackman.
I think that trying to make a profit should be a good thing for any business, and investors in those businesses should make a profit from their shares.
Capitalism, anyone?
Best wishes and thanks for reigniting the debate
Savio
Thanks for providing your perspective, Savio. I agree with you completely.
Your argument is silly, David.
I'm guessing you've been reading Steven Pearlstein's columns touting the work of Lynn Stout and William Lazonick. They're silly, too, and I've written to him saying so.
The problems are that (1) you fundamentally miss the point of the shareholder value argument, (2) you ignore the conclusions of literally thousands of empirical studies of corporate behavior, and (3) you misrepresent the lesson of the 1970s.
(1) The argument in favor of shareholder value is not that corporate managers should maximize shareholder value even if it's bad for the corporation and the broader society/economy: it's that truly maximizing shareholder value means taking actions that are BEST for the corporation AND the broader society/economy. That's why Lynn Stout's work on the legal basis for maximizing shareholder value is silly: she writes that maximizing shareholder value comes at the expense of "aggregate shareholder wealth over the long term"--but those are exactly the same thing.
(2) Lazonick's thinking is equally silly, because he assumes that corporate managers would make investments to benefit the corporation if only the money weren't diverted to pay dividends. There are two problems with this argument:
(a) What's going on now is that corporate managers don't believe that genuinely good investments are available, so they have come to the conclusion that the only use of the cash that benefits the corporation is to do stock repurchases. If they're wrong, then the problem is that corporations are being run by people who don't see the good investments available to them. But the presumption should be that they are in the best position to understand the value of each possible investment--especially to the extent that their actions are subject to capital market discipline--so you and Lazonick need to start providing some evidence that they're wrong. And simply claiming "there’s little doubt that capital used to fund many buybacks over the past decade has been diverted from more worthwhile investments" does not count as providing evidence!
(b) Michael Jensen's seminal 1986 article "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers" has now been cited more than 16,000 times according to Google Scholar. The basic finding, which has been supported again and again empirically, is that corporate managers tend to waste available cash by spending it on projects that benefit themselves but that are poor investments. What we as society want is to take cash out of the hands of those people. Jensen talked about doing it through dividend payments, and that's a good idea; the problem is that corporate tax law provides an incentive for doing it through stock repurchases instead--but the point is that both ways accomplish the main task, which is to get cash away from people who are likely to do stupid things with it.
(3) What happened in the 1970s was that corporations hadn't distributed cash--through either dividend payments or stock repurchases--and instead had made exactly the kind of bad investments that Jensen warned about, building unwieldy conglomerates that served mainly to increase the pay of CEOs because their compensation was tied to the size of the corporation rather than its performance. The LBO boom was about taking apart those stupidly constructed conglomerates so that each piece could be run by someone capable of running it well, with each piece subject to more effective capital market discipline. We don't want to go back to those days.
There's nothing wrong with saying that corporate CEOs are doing a bad job (witness, for example, the decision by IAC to put Chelsea Clinton on its Board of Directors--a favor to Barry Diller, but not in the interests of good corporate governance); there's also nothing wrong with saying that LBO managers are doing a bad job; and there's nothing wrong with saying that activist investors want to make money with short-term actions at the expense of long-term investors. But it's silly to argue that one of the actions taken to maximize shareholder value--getting rid of cash because the only available investments are stupid ones--is bad for corporations or society.
Kudos to the author for discussing this complex question.
I came to this blog via google because I was curious about CFA exam questions on share repurchases. On another website I found a reference to the CFA Program Curriculum (2015), Volume 4, page 128, question 38.f.: "explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders' wealth, all else being equal."
Whenever people in finance write "all else being equal", that alone tells me they have no valid scientific arguments for their claims. If finance professors were properly trained in deductive reasoning and basic algebra, calculus and probability theory they should realize that share repurchases and dividends are NOT equivalent. The proper math is outlined here:
http://hvass-labs.blogspot.hu/2014/02/how-to-value-apples-share-buyback…
Oops, I meant to post this as a general comment to the blog-post.
Thanks for your contribution, Magnus.
One good empirical study of the motivations for, and responses to, share repurchase programs is by Grullon & Michaely and is available at http://forum.johnson.cornell.edu/faculty/michaely/the%20information%20c…. Among other conclusions, the authors find that "repurchases and dividends are motivated by similar factors. When future investment opportunities are contracting, an increase in cash payouts conveys important information about management commitment to reduce the agency costs of free cash flow when those costs are potentially more pronounced."
your arguments are very good but too long , be brief, Brad Case
Brad,
I think you are the one being silly. You said, "truly maximizing shareholder value means taking actions that are BEST for the corporation AND the broader society/economy."
Defense stocks are up, maximizing shareholder value in defense sector means lobbying for wars, is that in the best interest of US economy and society? But isn't that what the defense sector has been doing?
Reader Milton Friedman again (who is also referred to in the article by the writer) There is no broader society/economy in Friedman's post.
You can maximize shareholder value in a world in which there are no externalities. Wherever that world is, it is not on earth!
Sharoon, I don't know what you mean by reading Milton Friedman's post: Friedman died in 2006, and if posted a blog on this topic I haven't heard of it.
More importantly, it's simply not true that "maximizing shareholder value in defense sector means lobbying for wars." I won't deny that lobbying can increase shareholder value (witness, for example, the effectiveness of Franklin Raines in lobbying the Clinton administration to relax constraints on Fannie Mae and Freddie Mac, which started the subprime mortgage crisis), but maximizing shareholder value goes far beyond lobbying: it means deploying capital in the most efficient ways--whether that is R&D investment, higher pay for certain categories of employees, lower pay for certain categories of employees, increasing the sales force, improving the budget process, paying dividends, or (yes) buying back shares.
Savio,
Thank you for sharing your perspective and for your thoughtful comments.
I’m all for profits too and I agree that activist investors can be effective corporate watchdogs. At the same time, I think CEOs of public firms have an obligation to build sustainable enterprises, which requires looking beyond the next quarter. It’s hard to do that without investing in innovation and employees. I question the motivation and decision-making of management teams that choose to borrow money to fund share repurchases with their stock prices near all-time highs.
Regards,
Dave